Stock analysis: Geox spa - the breathing shoe's corporation

Geox spa is one of my favourites blue chips on the Italian stock market. Geox creates, produces, promotes and distributes patented shoe and apparel products all over the world. It operates in the men's, women's and children's classic, casual, sports and fashion business.


Geox main competitive advantages are:

1. Technology: constant focus on the product with the application of innovative and technological solutions developed by Geox and protected by patents.
2. Focus on the consumer: cross-market positioning for products, with a vast range of shoes for men, women and children in the medium to medium/high price range (family brand).
3. Brand recognition: strong recognition of the Geox brand thanks to an effective communication strategy and its identification by the consumer with the "breathing" concept.
4. Internationalization: a growing presence on international markets thanks to easy replication of a business model already tried and tested in Italy.
5. Distribution: a network of monobrand Geox Shops in Italy and abroad which has been developed according to each country's distribution structure and calibrated to the widespread network of multibrand clients. The goal of both networks is to optimize market share and, at the same time, to promote the Geox brand to end-consumers on a consistent basis.
6. Supply chain: a flexible delocalized business model with considerable outsourcing, capable of efficiently managing the production and logistics cycle while the Company maintains control over critical phases of the value chain, so as to ensure product quality and timely deliveries.
   

Geox is the 1st shoe brand in Italy and the 2nd in the world. Since the start of 2008 the company is a member of the S&P/MIB index, the leading blue chip's index for the Italian stock market.

Let's take a look at Geox 2008 results (the images are taken from Geox 2008 financial statements):



Net sales were up 16% thanks to new store openings. Comparable DOS (directly operated stores opened for at least 1 year) sales were up 3%.
The rise in sales was not enough to offset the strong increase in general and administrative expenses, caused mainly by new store openings, especially flagship stores.
As a result EBIT margin contracted to 19,1% from 23,4%.
Net profit margin contracted less to 13,2% from 16% thanks to a lower tax rate (29,2% in 2008 vs 31% in 2007) due to a one time fiscal item.
EBIT and net income were also negatively affected by asset impairments by 2 mln and 5,9 mln respectively. Diluted EPS were 0,45 in 2008 vs 0,48 in 2007, a contraction of 6,25%.

Let's take a closer look at sales:



Geox is trying to further expand it's sales by selling apparel equipped with it's breathing technology in addiction to shoes. Due to it's high growth rate apparel is becoming increasingly more important as a source of revenue for Geox. In 2008 it generated 9,4% of net revenues as opposed to 6,7% in 2007, with a grow rate of 62,5% compared to 12,5% for shoes.

Geox main market is it's home market, Italy, which generated 37,3% of it's sales in 2008. In the last years the company successfully expanded in other European countries like Germany, France, Spain, Austria, in the US and in emerging markets (rest of the world). If you look at past balance sheets you can see than the company is progressively expanding the percentage of revenue generated outside Italy. In 2008 it continued to purse this strategy with important Cap Ex (capital expenditures) - roughly 94 mln euro - committed to opening new DOS (especially flagship stores) all over the world.

As you can see in the image the percentage of sales generated in DOS sales has increased in the last year, increasing to 15,8% from 13,1%, while the percercentage of revenue generated in franchising stores remained stable at 16%.

...to be continued...

Why Volatility isn't an adequate measure of risk

Nowadays, the most popular indicator of a security's risk is volatility. As we all know volatility measures how much the price of a security has fluctuated in the past. People see volatility as a risk indicator because, they say, if you buy a high volatility security you will expose yourself to a greater drop in the security value than if you buy one with low volatility. That's true, but the price movements that occur in the short term hardly tell something about the intrinsic risks of a business.

It's no surprise that this statistical concept has become so popular in modern markets dominated by traders which operate with very short time horizons. Those market players generally don't act on a value basis and don't know the characteristic of the business they buy or sell, instead their operations are based on their ideas of future price movements. To them, a simple price fluctuation based indicator like volatility appears very useful. They use it to estimate the potential loss/gain of a trade.

Unfortunately for them they learned the hard way one of the shortcomings of volatility: what happens tomorrow may be really different than what has happened in the last day, month or year. In 2008 while stock kept falling volatility drastically increased, reaching peaks not seen since 1987 in September-October after Lehman Brothers bankruptcy. Short term investors experienced bigger adverse developments in market prices than what they had estimated using volatility, beta and VAR. That's why many traders and hedge funds were utterly crushed by the market in the meltdown after September 15th.

The volatility of the S&P 500 is now higher than in 2006-1H 2007, but it's price is much lower. If one values risk on volatility he would come to the conclusion that the S&P is now much riskier than in 2006-1H2007. This is against any sound reasoning. How in the world can you assume a higher risk if you buy something at a much lower price?

Let's suppose than in year T you estimate that the stock of X corporation has an intrinsic value of 100. It's market price is 110 and it's volatility 20%. In year T+1 it's price falls to 60, it's volatility increases while it's intrinsic value is little changed. By buying something worth around 100 at 60 you would have an adequate margin of safety reducing significantly the risk of permanent losses, still volatility indicates than the risk of the security has increased! The intelligent investor understands that this is total nonsense and uses other reasonable methods of risk measurement.

The last problem with volatility is that it doesn't tell nothing about the intrinsc business risks. You will have to study the business until you understand it and read the financial statements to have a grasp of the intrinsic risk of a complex thing like a corporation.

Exploiting market fluctuations: the metaphor of Mr. Market

One of the best explanation of the market's behavior and the correct way to exploit it is Benjamin Graham's metaphor of Mr. Market.

Let's suppose you own a small amount of shares in a private business, which you payed 10000$. One of your partners, named Mr. Market, everyday tells you what he thinks your interest is worth and offers you to buy you out or to sell you an additional interest on that basis.

Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Other times on the other hand he let's his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short or silly.

If you know the business you own and you have an idea of it's value, you won't be influenced by Mr. market opinion on the value of your 10000 $ interest. Instead you will take advantage of his misjudgements by buying from him when the prices appears too low and by selling him your stake if the price appears ridiculously high. The rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about it's operation and financial position.

The value investor is in that very position when he owns a listed stock. He can take advantage of the daily market price or leave it alone based on his judgements.

Price fluctuations have only one significant meaning for the value investor: they provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market fluctuations and pays attention to his dividend returns and to the operating results of the companies he owns.

Never let the opinion of the general public influence your action. Stick with what you know and take advantage of the market's foolishness.

"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and your reasoning are right" - Benjamin Graham

The automotive sector crisis and two thoughts on Fiat spa

The automotive industry is in a very serious crisis. The US automobile market has been literally collapsing forcing the US Government to step in and save GM and Chrysler with a multi billion emergency loan. Ford is not in a much better situation, having burned more than 5 billion dollars in the 4Q 2008 alone. The Japanese automakers (Toyota, Honda, Nissan) which have a very important percentage of their sales in the US are also under pressure. Their situation is worsened by the strengthening of the yen against the dollar and the euro which is caused by the unwinding of the carry trade and the fall of interest rates in both US and Europe. Toyota has lost its AAA rating and has announced that it now expects an operating loss in 2009.
The European market has also experienced weakness in 4Q 2009 and major players now expect global sales to shrink by 20%-30% percent in 2009.

Right now I'm bearish on both equity and bonds of those issuers, but I'm following the sector because i think that some opportunities could arise as soon as late 2009 or in 2010 since many issuers could be downgraded by the rating agencies (we may even see some fallen angels, corporations which lose Investment Grade status and become High Yield issuers, with usually very negative consequences for their outstanding bonds) and the default of a big player in the industry could happen, putting considerable pressure on the price of automotive bonds.

Fiat spa (the main Italian automaker) released 4Q&FY 2008 results some days ago, i think that some figure are especially interesting to understand what's going on so let's give them a look (the pictures are taken from Fiat spa presentation for the analysts):


Let's take a look at Fiat cash flow in 2008 (click on the image to see the enlarged version). As you can see the company, despite it reported record trading profit in 2008, generated an operating cash flow of only 156 m euro. The reason is the adverse development in NWC (Net Working Capital = Inventory + accounts receivables - accounts payables), which absorbed 3,604 m euro of cash. We will return on this later.

Capital intensive business like this need very huge investments to continue to operate and to remain competitive, Fiat had a very heavy CAPEX (Capital Expenditures) in 2008: nearly 5 billion euro. The pathetic operating cash flow could do nothing to cover this absorption of cash and Fiat net industrial debt increased by a whopping 6,304 m euro.

This level of cash burning is obviously not sustainable, if things don't improve soon they could have difficulties in refinancing their debt and honoring their maturing obligations.
The problem is that what has happened in the US is now happening in the European market: auto sales are plunging. EU auto sale fell 27% in January 2009.
The EU market will shrink by roughly 20% in 2009 according to estimates, and it may non recover in 2010.
Fiat trading profit in 2008 could transform in a substantial loss in 2009, and the cash burning process will probably go on. Additional cash could be soaked up because of adverse developments in NWC (the more the net working capital increases the more it sucks up cash, the opposite is also true: the more it decreases the more it frees up cash).

Let's take a look at the development of Fiat's NWN in 2008:

Take a look at the increase in inventories as the revenue goes down. Like many other competitors Fiat is tryng to reduce inventories while sales are falling by temporary shutting down production in factories.
So we should expect inventories to fall, reducing NWC.
Trade receivables follow revenue, so we should expect them too to contract reducing NWC.
The problem is that trade payables are falling too due to the production stoppage.
The increase in NWC due to the fall in trade payables could more than offset the decrease in inventories and payables.
That's why i think that NWC could soak up cash again in 2009.

So you end up with a negative operating cash flow and you have to finance the CAPEX, which will be more conservative in 2009 than in 2008, but will still be there.

This means that debt will increase even further.

Lets take a look at the breakdown of Fiat net financial debt:

The net financial debt increased to 17,9 billion euros in 2008. Fiat draw 2 billion of committed lines in 4Q 2008, exhausting all it's remaining credit lines.

17,9 billion of debt becomes a problem when you are going to generate negative cash flow, especially if you have heavy short term maturities:


Fiat has 4,8 billion of total cash maturities in 2008 and 3,9 billion in cash & marketable securities. The only way it can repay them with a negative cash flow is by renegotiating them or contracting new debt.

Right now Fiat is negotiating a 3 billion credit line with some big Italian banks.

The next quarters will tell us if that's enough to cover it's financial needs.

Value Investment: what is it?

That's my first post on this blog and i will use it to introduce you to what i think is the investment philosophy that grants an active (or enterprising, as Graham called them) investor the highest chances of success during his investment career.

The value investment thinking school was developed by Benjamin Graham and David Dodd, two professors of Columbia Business Schools and teachers of many famous investors (the most famous of them is Warren E. Buffett, the "Oracle of Omaha"). Benjamin Graham was also a financial analyst and a successful investor: his Graham-Newman Corp. gained an annual compound return of 14.7% from 1936 until he retired in 1956 against a compound return of 12.2% for the US market.

Graham, after surviving the terrible market crash of 1929 (during which the Dow Jones Industrial average index lost almost 90% of it's value) at the expense of painful losses, was inspired to develop a more conservative and safer way to invest. After spending some years developing his new way of investing while teaching at Columbia, Graham finally published the book Security Analysis in 1934 with the aid of David Dodd. This book represents the genesis of fundamental analysis. Graham explains than the market gives too much attention to current earnings and earnings forecasts, which most of the times prove to be unreliable, instead the market should place much more attention on the past performance of the business. To determine a company value the investor should carefully analyse it's past financial statements.
Graham also suggests to the enterprising investor to look for companies that have low market multipliers (like price/earning, price/book value, price/tangible asset value, price/cash flow) because generally those stocks are less susceptible to adverse market developments than those trading at high multipliers.
In 1949 Graham publishes The Intelligent Investor, which is considered the bible of the value investor. Warren Buffett describes it as: "by far the best book on investing ever written". This book is written for the general public and its greatest merit is to describe the specif intellectual framework an investor needs to survive and thrive in the market.

The 3 main ideas behind value investment are simple and rational:

1. Look at stocks as business: the investor should think of stocks not like small piece of paper whose prices moves up and down randomly but as what they truly are: small pieces of a real life business, which produces products and services and employs people. The value of a stock depends on the value of the business behind it (what Graham calls intrinsic value), and while in the short term the price performance of a stock may outperform/under perform the performance of the business, in the long term the performance of a stock will reflect the performance of the business.
2. Take advantage of the market's fluctuations instead of being fooled continuously by them: now that the enterprising investor know that what he must look at is intrinsic value and that business may sell in the stock market at prices that can be much higher or much lower than their intrinsic value because the market sometimes gets carried away and ends up being too optimistic or pessimistic, his objective is to study stock and determine their intrinsic value. When he as an idea on the true value of a stock, instead of letting himself get carried away by the mood of the market, he can take advantage of that by buying it cheap in a depressed market and by selling it dear in a euphoric market. Graham explain this concept with the effective metaphor of Mr Market, which we will talk about at another time.
3. When you invest, be sure to have an adequate margin of safety: after understanding how he should operate, the hard part of the work of the enterprising investor is the determination of the intrinsic value of a stock. In fact, it's so hard than even for investors with great financial knowledge and experience it is impossible to make a 100% accurate estimate of the intrinsic value of a business. That's because the value of a business may depend also on future developments which are impossible to predict (an extreme example is 09/11/2001: it was an impossible event to predict and it caused terrible losses to many insurance and airlines companies) . It's also more frequent for this developments to be on the negative side than on the positive side. The investor can do two things to maximize his odds of succeeding: he must do everything he can to minimize the error of his valuation and he must make use of a margin of safety to minimize the negative consequence of the risk of being wrong. There is a margin of safety when the price of a stock is inferior to the estimated intrinsic value: the greater the difference, the greater the protection against the risk of having overestimated the intrinsic value of the security.
   

By reading this introduction you have probably understood that the value investor invest in the long-term and doesn't even try to predict the next move of the market, simply because the market fluctuation in the near term are impossible to predict. It's just a waste of time and energy. What you can do is to evaluate what you are getting for the price you are paying.

Now let's get to our days. It looks like that the market has finally returned, after all those years of too generous valuations, to an interesting level for value investors which patiently waited in the certainty that sooner or later all bull markets must end badly and stocks have to return to rational valuations. Since the start of the current financial crisis in July 2007, probably the worst financial crisis for the US since the Great Depression of 1929, the S&P 500 index has lost more than 40% from it's peak in October 2007, European and Asian index have suffered even worse losses. Stock are in my opinion at a level of attractiveness not seen since the early '80 at an early phase of the greatest bull market in history that culminated in the dot-com bubble.